How to analyze an earnings report — Part 5: AMC case study

Published Tue, Oct 11 20229:29 AM EDTUpdated Tue, Oct 11 202212:20 PM EDT

Throughout our series on reading financial statements, we've used earnings reports from Apple (AAPL) for a reason: The tech giant has one of the most bulletproof financial positions in the world. However, we think it's helpful to also take a look at a company that has a shaky financial position. This will help us better spot red flags. Our pick is the highly controversial meme stock AMC Entertainment (AMC). We know lots of folks love this company. Perhaps, it's the nostalgia of going to movie theaters or maybe it's AMC's charismatic CEO, Adam Aron. But our intention is to take a cold, hard look at the financials to determine the worthiness of AMC stock as an investment because, just like on "Mad Money," we are not about friends — and Aron has been on "Mad Money" many times — we're about making money. In this Part 5 case study, we can apply some of what we covered in Part 1 : The income statement; Part 2 : The balance sheet; Part 3 : Cash flow analysis; and Part 4 : The ratios. We'll begin our AMC analysis by taking a look at the last eight income statements from the company. We could obviously go back further, but eight provides a good amount of data to understand the path the company is on — from the depths of the Covid-19 pandemic though the gradual reopening. We will briefly reference pre-pandemic numbers for comparisons. To simplify, we reformatted the financial statements using excel and added some additional information such as profit margin percentages and growth rates. So what do we see? For starters, we see a significant bounce back in admissions to movie theatres since the height of the pandemic, with $651 million tickets sold in the second quarter of 2022 (represented in millions as $651 in the release). It's indicated by the annual revenue growth rates, with Q2 revenue of $1.17 billion. But that growth is clearly decelerating, and how much more revenue upside is left remains a key question for any potential investor. We see a nice rebound from the first quarter to the second quarter in 2021, as indicated by the sequential growth rate. But that may be due more to seasonality than anything else, as AMC's first quarter appears to have a tendency to be weaker following a strong fourth-quarter movie release season. This is something we saw digging back through pre-pandemic statements, too. Overall sales look good, but they are not yet not back to pre-pandemic levels. Whether they ever will be is for the individual investor to determine. The incredible ramp up of streaming content is a major headwind for movie theaters. Another consideration is the potential for a recession. Going to the movies is a discretionary expense — and costly, especially when you consider the relative value of all sorts of streaming services that you can watch in the comfort of your home with your own popcorn and candy. Sales are only one headline number. In the case of AMC, it's the expenses that are of primary concern. Operating costs and expenses of $1.18 billion in Q2 outweighed total revenue, meaning that the cost of operating the company is higher than the company's total sales — an obviously unsustainable dynamic. On the other hand, AMC management is on the verge of breaking even on an operating profit basis, with just a $16.1 million loss in the second quarter. Put another way, they could get a bit more leverage on marketing, cut structural operating costs, or perhaps simply enhance the margin by charging more for food and beverages. AMC could eke out an operating profit, if demand remains strong. Still interested? The next step is to analyze what management is saying on conference calls and at investor events to determine whether the strategy has merit, or is simply wishful thinking. One nice thing about AMC is that CEO Adam Aron has been an open book when it comes to the path ahead and appears ready to consider every opportunity. Unfortunately, operating expenses are only part of the expense story. The "other" expenses must also be considered, especially — in AMC's case — interest expense. AMC has a lot of debt, costing it about $80 million per quarter just to service it. We find this by looking at the "corporate borrowings" line item. Then there's also expenses related to investment opportunities, slightly more discretionary but highly important given that AMC must grow revenue in order to survive. Management still has to get to operating profitability before they can even think about being profitable on a net income basis. And that's the only basis that matters in the long run. Looking at net income, we can clearly see that the business as it stands today is a money loser, with a net loss before income taxes of $121 million in Q2. However, as was the case with operating profit, we are seeing a trend toward profitability as indicated by the net profit margin over time. Again, it's on the investor to make a decision about where the business goes from here, and if it is a good gamble. This is not the income statement of a sustainable business. While losses may be acceptable for a rapidly growing business with large addressable market opportunities, the concern with movie theaters is that it's an old business in decline as streaming catches on. How long can AMC last? Just how long AMC can survive at these loss rates will depend on how much cash it has on hand (a balance sheet question), its cash burn (a cash flow statement question) and management's ability to raise additional funds, if needed, via debt and/or equity offerings. The cost of additional debt will not come cheap given the already-high debt burden, and with every equity offer comes more dilution for existing shareholders. With those thoughts in mind, let's hop over to the balance sheet, pulled from AMC's 10-Q. For this, we are only going to concern ourselves with the most recent release, since we are most concerned with the current financial health of the company. The cash and debt figures from a year ago are of little importance when thinking about the future. The first red flag is the current ratio (current assets divided by current liabilities, or $1.21 billion divided by $1.62 billion) stands at about 0.75. A ratio less than 1 means AMC does not have enough liquid assets on hand to cover upcoming liabilities. AMC's current ratio can get closer to 1 if we adjust the liabilities by removing the impact of deferred revenue and income, as it won't involve a cash outlay. This figure is likely related to movie tickets that were already sold for screenings not yet attended. After doing this, we're not quite at a 1 ratio. But closer, and close enough that management may be able to make up the difference by stringing together a few positive quarters. It could also sell more equity, to the detriment of current shareholders. Additionally, the company recently said it has access to "undrawn revolver lines," though added that it "does not anticipate the need to borrow under the revolver lines during the next twelve months." Liquidity vs. solvency The current ratio is all about liquidity — and shows AMC needs to figure out a way to come up with cash to pay near-term obligations, be it an equity sale or debt offering. But since total debt also outweighs total liabilities, we also have a solvency issue. That means there are questions about the company's ability to continue operating in the future as a so-called going concern. The difference between liquidity and solvency is that the former is simply a question of being able to raise cash quickly to meet near-term obligations, whereas the latter relates to a company's ability to pay off debts in the long term. A company that can meet near-term obligations may be considered liquid, but if it can't meet large obligations in the future it may become insolvent. As it stands now, shareholders are in an equity deficit. If the company liquidated right now there would not be enough cash or monetizable assets available to make good on the company's financial obligations. In the event of bankruptcy, not only would equity holders get nothing, but lower-tier debt holders may not see a dime either. How AMC added liquidity Management has attempted to address their liquidity issue in the past, taking advantage of 2021's meme-mania by selling 8.5 million shares to Mudrick Capital, which quickly flipped them for a profit for $27.12 per share — raising about $230.5 million. In a brilliant move, AMC offered 11.55 million shares at an average price of approximately $50.85 per share, raising an additional $587 million near the peak of the mania (on a closing basis, shares topped out at $59.26 on June 18). Over $800 million isn't bad, however, it was nowhere near enough to address the company's debt- and cash-burn rates. Of course, if the equity dilution wasn't enough to convince you that shares may have been overpriced back in 2021, Aron also sold 625,000 in what he said was an "estate planning move." The shares were sold at an average price of $40.53, totaling roughly $25 million. He then proceeded to sell additional shares through the end of 2021, bringing the grand total to roughly $42 million before announcing that he was done selling. At the time, he still had over 2.3 million shares, nearly all of which were unvested. We can't fault Aron for making the sales, as he told investors he would ahead of time and has been as transparent a CEO as any retail investor could ask for throughout the mania. Perhaps the real moral of the story here is that when you have a balance sheet this bad, do what the insiders are doing. More recently, management was forced to up their creativity after shareholders said enough to the equity dilution. The solution? To offer up AMC Preferred Equity (APE) Units. Initially, the APE offer, despite representing a different class of stock with its own ticker, was done in the form of a dividend pay out to existing shareholders. This impacted the stock in a similar way that a 2-for-1 stock split would, with AMC shares falling by over 50% in the days leading up to, and through, the day of the distribution. The decision to offer up a new class of stock is not unheard of, however, it is a bit questionable in AMC's case. Unlike the preferred shares of other companies that may provide unique characteristics such as different voting rights or a larger dividend, AMC's APE units were designed to have the same economic value and voting rights as shares of Class A common stock. In the event of bankruptcy, preferred unit holders should have a higher priority claim on assets than common shareholders. However, as it stands now, it's doubtful anything would be left over after the bondholders would finish making their claims. Regarding any future conversion to AMC common, such a move would require the board to make a proposal and shareholders to approve it. That gives us some insight as to why these APE units were even developed to begin with. Prior to the APE announcement, AMC tried and failed to gain wide shareholder support to authorize the sale of additional common stock. However, since these APE units are not technically AMC common stock — despite their similarities — they did not require shareholder approval, effectively providing management a with a new avenue to raise funds. Importantly, the initial distribution did not provide new funds or dilute existing holders since they went to the existing holders (again, similar to a sock split) as a dividend. However, while a grand total of 516.82 million APE units were distributed in August (1for each share of common outstanding), 1 billion APE units were actually authorized. Indeed, shortly after the initial APE dividend payment, management filed that they had entered into an equity distribution agreement to allow for the sale of the remaining APE units (425 million in total after holding some back for compensation). Management has said this distribution agreement was made in an effort to raise cash to pay off its debts. But while it may not be technically dilutive, AMC common shareholders have another class of equity coming in higher up in the capital structure. For a shareholder, the positive is that this plan gives AMC ample liquidity to meet its near-term obligations and buys management time to figure out how to get to profitability. The negative is that the authorization of 1 billion shares opens up the equity base to dilution when those shares that were not distributed as a dividend are sold, even without a vote to authorize additional shares. Solvency remains a longer-term issue and the main concern for those holding equity or low-seniority debt. What is the AMC brand worth? Another line item of concern is assets attributed to "goodwill." Goodwill is an intangible asset: it's not cash, it's not receivables, and it's not really something that can readily be converted into a liquid asset. It's management's best guess at what the AMC brand is worth. As of Q2, it was $2.35 billion. If the business prospects decline — sales fall short of expectations — management may be forced to reduce goodwill via what is referred to as an impairment charge to reflect the loss of brand value. The balance sheet takes a one-two punch: Cash levels come in lower-than-expected (because actual results didn't match up to expectations) and goodwill (and, therefore, total assets) is reduced. This negatively impacts financial ratios. Indeed, we saw "goodwill non-cash impairment charges" of roughly $2.3 billion taken in the year ended Dec. 31, 2020, due to the impact the pandemic had on the "the enterprise fair values" of the Domestic Theatres and International Theatres reporting units. That may not have been a cash hit, but the negative impact it has on shareholder equity could certainly lead to higher borrowing costs. As to the $80 million in corporate borrowing interest payments we noted in our review of the income statement, we can see that the actual debt load causing these costs is about $5.36 billion in total corporate borrowings. Until management can make a dent in this principle, investors should expect those interest payments to continue at around the same rate. Call it somewhere in the range of $300 million to $350 million per year. While some of that debt was necessary just to survive the pandemic, whether management can pay it down, and how quickly, will depend heavily on the team's ability to reach operating profitability and sustainably generate cash. So after considering the income statement and balance sheet, we are looking at a company that is losing money and does not have the ability to meet its financial obligations. That is the reality, as indicated by the most recent financial statements. The only reason AMC is even standing right now is because of the meme-mania we saw during the pandemic, a hysteria that allowed the company's management to both sell equity into a buying frenzy and raise debt in a world where the cost to borrow was very low. We are no longer in that world. Borrowing costs have increased significantly and the buyers that fueled the stock's prior price surges appear to have given up on AMC, or have run out of money. AMC's cash flow Let's finish by taking a look at the cash flow statement. Rather than analyze each individual line item — though members may do so here , as management must provide the statement in full on their 10-Q filing — we will instead focus on the consolidated statement on the operating, investing, financing and free cash flow totals over the most recent four quarters. The investing cash outflow (line one) is to be expected, as management is putting money to work to ensure growth and to get to profitability. The financing cash outflow (line two) shows a slow paying down of the massive debt load that's weighing on the company's balance sheet. What we really want to focus on is operating cash flow (line three), followed by capital expenditures and then free cash flow. AMC has not been able to consistently generate positive cash flow from operations. This means it must either sell assets or look to the bond and/or equity markets in order to find cash. Even in the fourth quarter, it didn't generate enough cash flow to cover the investing and financing outflows, not to mention capital expenditures. Once again, we have an unsustainable financial dynamic: a company simply cannot survive if it is unable to generate cash internally. The individual investor has to determine if management has a plan to turn the ship around and get the company back on track. If you believe they do, then that's the bet. Otherwise, there are no fundamental reasons to take a position in the name. Looking at the operating cash flow alone, AMC needs to make significant changes or it will eat away at cash on the balance sheet. Fortunately, current FactSet estimates do anticipate AMC having positive operating cash flow in 2023. But the projections still don't cover the projected investing and financing cash outflows. Estimates are for another $6 million to flow out in the back half of 2022 ($81 million out in Q3 and $75 million back-in in Q4) and another $154 million and $201 million to flow out in fiscal years 2023 and 2024, respectively (not accounting for any effect that exchange rates may have on cash balances). The takeaway: Cash levels should be expected to decline for the foreseeable future. Bottom line Based on our analysis of AMC's financial statements, the company is in trouble. Its stock price has fallen 76% year-to-date and the cost to borrow is climbing. Options to raise cash externally have become severely limited. Aron was smart enough to leverage the investor frenzy during the pandemic and the then-low borrowing costs to load up the balance sheet. Based on current burn rates and the roughly $965 million in cash, management has a couple years to figure things out. That's still an optimistic take. In the most recent 10-Q, AMC shows a $525.6 million payment due in 2023. The company said it is currently negotiating terms of new debt intended to refinance and extend the maturity of that money owed, but "there are no assurances that the Company will be able to do so." If AMC is unable to refinance these amounts, the principal amounts will be reported as current maturities, which may increase the uncertainty around the company's ability to pay its debts. This renegotiation should be on the radar of every AMC investor and prospective investor. A failure to make do on a new debt agreement will mean a significant cash hit in 2023, and reduce the time on the clock for AMC to turn things around. The next big challenge will be the $3.36 billion in maturities due in 2026. We can cross that bridge when (and if) we come to it. Unless you believe that the movie theater business is about to reignite and the trend we have seen in recent years of viewers trading in the theater experience and $20 popcorn for some Disney+ and microwave popcorn, then there is little reason to be involved with AMC. We would love to see management pull this turnaround off, reinvent the company and provide consumers with an experience they've never seen before. But we have our doubts about management's focus on the core business, given past moves such as investing in the completely unrelated business of a gold mining company . Understand that any position taken in AMC at this point is entirely a bet on management and Aron's vision. To be clear, though we don't predict a bright future for AMC based on its financial position and our own view of the changing consumer preference toward at-home streaming services, we find little fault with Aron. This is not a good hand he is playing with, but he appears ready, willing, and able to do anything and everything he can to save the theater chain. Some may argue that he took advantage of a generation of meme-stock investors. In our view, his transparency throughout the timeline going back to the early days of the pandemic negates that narrative. Instead, we think Aron acknowledged that his shareholder base is majority retail and opted to view and treat that base as members of a club, seeking to listen to what they wanted to see management do with the company — be it showing concerts or selling nonfungible tokens — and then see what financial means the company had at its disposal to do something, anything to get the company back on a path to profitability. (See here for a full list of the stocks in Jim Cramer's Charitable Trust is long.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. 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AMC Movie theatre in New York.

Scott Mlyn | CNBC